If workplace retirement schemes were cars, then defined contribution would not be a luxury brand: a Skoda or Nissan perhaps, but certainly not a Lexus or Mercedes. Like other individual savings accounts, defined contribution (DC) vehicles come with no guarantee.
If something goes wrong, its owner has to fix it himself, either by settling for a smaller pension or making larger contributions. The employer – no matter how big is not responsible for any losses.
The liquidity crisis of 2008-09 demonstrated the peril of individualism. According to the
Dutch Association of Pension Funds (OPF), many workers retiring during this period might have seen their expected income plummet by 25%. And not just for the period in question; for the next 15 years. By contrast, defined benefit (DB) arrangements, promise a comfortable ride to retirement.
If there are any nasty stock market bumps or potholes along the way, the employer has to pick up the tab. OPF calculations for DBs suggest that, though a worker would lose a little due to the crisis, by age 80 he would be enjoying a pension twice that of his DC neighbor. The inferior reputation of DCs to DBs, however, has less to do with design and much to do with the amount of money paid in. For example, over the last three years DB schemes in the United Kingdom have received contributions of £100 billion ($145 billion) versus just £5 billion ($7.25 billion) for DCs.
This imbalance can be partly explained by the increasingly conservative regulation of worker DB pensions. When stockmarkets take a serious tumble, the employer must come up with a lot more cash than he would have in the past. Employers in the United States and United Kingdom have been worn down by this obligation so that whenever they get a chance to close DB schemes, they offer relatively miserly DC replacements instead.
This story is far from global. Australia’s compulsory DC model has amassed the fifth-largest pool of occupational pensions in the world. Under the influence of the World Bank, Latin American and CEE countries have established universal DC systems over the past two decades, which has helped Poland save €43.5 billion ($53.5 billion) and Chile $100 billion.
But has any country been able to steer successfully through DB and DC plans at the same time? Poland and Chile never had the former. The United Kingdom and the United States are struggling to achieve the latter.
Dutch pensions at a glance
DC plans remain a small percentage of Dutch occupational retirement provisions: just over 7% of all funds as at the end of 2008, according to De Nederlandsche Bank (DNB).
This has much to do with the concentration of the country’s savings. Although there are 567 funds, just two – those for civil servants and health-care workers – account for half of all assets. The largest, ABP, can trace its roots back to 1922.
Both, however, have already reformed their provisions in the last decade. In view of findings of two major national reports, further changes can be expected. Jean Frijns, ABP’s former head and author of one report, likens these funds to “aging giants who, if things go badly, could end up in the position of sinking giants.” Clearer risk sharing among members and sponsors is called for. So expect to see more collective DCs.
ENTER THE DUTCH
The Netherlands is an anomaly. Its widespread DB system is able to shift gears into DC without a glitch in expected standards. “The Dutch tradition of social responsibility is that you have to care for your employees and this means paying more,” says Joeri Potters, senior risk manager at the Rotterdam consultancy, Cardano. “It might sound weird to business leaders in the United Kingdom or United States, but it’s a question of money’s time-value. A sound occupational pension today means the State won’t have to pay out welfare to poor retirees in decades to come.”
In order to achieve similar benefit levels, the Dutch start at the point of retirement. The goal is to provide the equivalent to two-thirds of a worker’s career-average salary. Contributions are calculated by working backwards from this target. With employees and employers expected to pay in jointly more than 20% of salary, the resulting demands are far higher than those of DC plans in other countries. Dutch employers in collective DC schemes (CDC) do not, however, face variable costs. Though high, they are fixed. And so, the second step in CDC is to better use the power of collectivity: members may face more risks, but if they do so together, the outlook is rosier.
DCs the world over leverage the size of the pool of assets in the form of lower costs for all. This is important because, 40 years down the road, an annual charge of 0.3% versus 1.5% can boost just one pension pot by 40%. But the Dutch model takes economies of scale further by sharing risk among all members. If funding falls below a contractually agreed level, then benefits are reduced in tandem. If funding exceeds a stated level, then benefits are raised. Such solidarity between members, not evident in individual DC plans, allows for superior risk control.
For example, investments for the Dutch flower-growing industry scheme are divided into two segments: secure and risk-seeking. The plan uses bond-like derivatives to ensure that the first, low-risk section achieves its promise of a return equal to wage inflation. The risk-seeking section is then free to invest in equities and real estate. If conditions are right, excess from the secure section could be used for risky investments. Moving investments from risky to secure however isn’t possible.
Much of the sophistication rests in the secure section due to the structuring of derivatives. “Even if an individual were able to understand this concept, they would seriously struggle to replicate what’s involved,” says Potters, whose firm designed the strategy.
So could CDC schemes help the financial world as a vehicle that saves employers uncertainty, but makes the most of group investing? Following a 2009 study by the Department for Work & Pensions, the United Kingdom decided definitely not. The very uncertainty of benefits was a major factor in their decision. British authorities were concerned that younger workers would be more likely to be disappointed by lower pensions than older workers (in theory the longer any structure exists, the greater the probability of failure).
Where the Dutch see an opportunity to share risks, the British see the potential for intergenerational strife. To return to our automobile analogy: if retirement plans were roadworthy vehicles, CDC would be the company bus. Other countries will have to decide if they wish to promote this kind of group travel.